Advanced Financial Reporting and Regulation - Essay Example

Advanced Financial Reporting & Regulation Contents Introduction 3 Fair value accounting method as a contributor to the financial crisis 4 Fair valueaccounting as a messenger of the financial crisis 6 Benefits and drawback of fair value accounting measurement 7 Benefits of fair value accounting 8 Drawbacks of fair value accounting method 9 Historical cost accounting 10 Deprival value accounting 11 Replacement cost accounting 12 Conclusion 12 References 14 Introduction The recent Great Financial Crisis (GFC) that started in 2007-2008 was an event that led to major changes in the way the global financial and capital markets function. Also, the intensity of the impacts of the GFC was so high that critics and scholars across various economic and financial fields entered into debates and arguments related to the exact causes of the GFC. The fair value method of accounting which was commonly used for the accounting processes of the big and small companies in the Wall Street was identified as a major triggering factor for the Great Financial Crisis (GFC). However, the proponents of the fair value accounting method argued that this accounting technique was just a messenger and not a major cause or contributor of the subprime mortgage crisis. The paper critically assesses the arguments that have been placed regarding the fair value accounting method being a main reason for the occurrence of the subprime mortgage crisis or the GFC. The idea as to whether the fair value accounting method has actually contributed to the financial crisis or has only played a constrained role in exacerbating the intensity of the financial downturn is evaluated and assessed by taking into consideration the views and arguments presented by different scholars and academicians in their literary works prepared and presented in this topic. The use of empirical evidences and descriptive information are made to analyze and assess the role of the fair value accounting method in the financial crisis. The second part of the report includes a comparison of the advantages and disadvantages of the fair value accounting method with the traditional accounting methods like the deprival value method of accounting, historical cost method of accounting and the replacement cost method of accounting. The report is concluded with a suitable conclusion in which it is highlighted that the role of the fair value accounting practice is much limited as a major reason for the occurrence of the Global Financial Crisis of 2008. Fair value accounting method as a contributor to the financial crisis The role of the fair value accounting technique in the financial crisis of 2008 is a controversial and highly debated topic. The fair value accounting method is the generally used accounting standard in the United States of America and has been specified in the FAS 157 in the year 2007. This accounting method includes the terms of accounting in which the different kinds of financial assets like the mortgage backed securities are priced and valued as per the current market value or mark to market value instead of being valued at the historical value or the future expected value or the deprived value of the assets or liabilities (Dickinson and Liedtke, 2004). A major drawback of the fair value accounting method is that when the market value of the financial assets become volatile and collapse then the losses incurred by the institutions who are holding these securities start having major impacts on the financial positions of the institutions even if these institutions do not have any immediate plans to sell of these assets (Hughes and Tett, 2008). As such, it is criticised by some opponents of fair value accounting method that the drop in the mortgage securities in the lending market of the United States of America from 2006 resulted in the volatility of the financial institutions and ultimately led to a deadly spiral effect of downturn in the entire financial market of the country (Chea, 2011). Fair-value accounting method is also known as the mark to market accounting method in which a price that is received by selling an asset or liability is paid for transferring the liability in the process of an orderly transaction that takes place between the market participants at a particular measurement date (Pennman, 2007). The fair value accounting method is defined on the basis of a framework in which the different types of liabilities and assets are categorised into three classes and the measurements of the prices of the assets and liabilities vary according to the classes to which they belong (Véron, 2008). The hierarchy of the value of the assets and liabilities according to the fair value method of accounting is given as follows: The assets and liabilities whose prices and values can be observed and decided on the basis of the active market of similar types of assets and liabilities. Those assets and liabilities whose prices or values can be set through the consideration of an inactive market or through the consideration of the inerrably developed models and information from the observable markets which deal in assets or liabilities of similar categories. Those types of financial assets and liabilities whose values cannot be decided from any observable market or similar market but are decided on the basis of the valuation or pricing techniques which require inputs of information from both significant and unobservable markets so that an appropriate fair value for the same can be decided. The basic proposition of the fair value accounting method which is the valuation of the assets at the current mark to market value is identified to be a cause for illiquidity of a financial market in the long term scenarios because this method takes into account the asset values at market prices which can change quickly due to the volatility in the financial and capital markets. If the changes in the values are not correctly accounted for, then it may result in increased illiquidity of the assets and in turn that of the markets as well (Andre, Cazavan, Dick, Richard and Walton, 2009). Thus, many scholars have argued that since the companies including business organizations, banking intuitions etc. mainly used the fair value accounting method for reporting their financial performances; therefore, this led to a certain level of incorrect valuation of the assets and liabilities which in the long term triggered the starting of the Great Financial Crisis (GFC). Fair value accounting as a messenger of the financial crisis However, many other scholars are of the view that there were a number of distinct reasons that led to the financial crisis of 2008 and no one particular reason can be identified as the primary cause for the crisis. As per these views, a number of institutional entities functioning in the capital and financial markets have been identified who can be said to have played the roles of messengers as well as contributors in the Great Financial Crises (GFC). These groups of entities include the credit rating agencies, the investment bankers, the banking and lending institutions and the financial statement preparers (Khan, 2010). The investor groups include the auditors, the Federal Reserve, the borrowers as well as the loan originators functioning in the financial and capital markets of the United States of America. The critics of the fair value accounting method blame this technique as the instigator of the subprime crisis by pointing out that the accounting technique used by the entities in the market created major difficulties in the way the subprime position of the assets and liabilities were valued in the market. These critics also claimed that this accounting technique contributed to the unacceptable level of leveraging that was used by the banking institutions while lending the mortgage backed securities during the boom period in the real estate investment domain (Alexandera, Bonacib and Mustatab, 2012). The process of the banks using the mark to market accounting during the real estate boom period created a downward spiral in the market when the prices of the mortgages started falling due to the credit payment failures in the trough periods. This forced the banking institutions to value their mortgage-backed securities at fire sale prices which were a major cause for the creation of lesser valuation of the subprime assets. These processes of valuation not only caused further fall in the prices of the mortgages but also intensified the contagions and tightened the lending principles of the market, thereby making it intensely illiquid and volatile (Magnan, 2009). Nevertheless, other economists have claimed that the ideology that the root cause of the subprime mortgage crisis can be uniformly identified as the bad mortgage backed loans but 80% of the actual crisis level has been intensified by the fair value accounting method or the mark to market accounting method which was used by the companies and which was inappropriate for usage in an intensely illiquid market (Laux, 2009). Though the argument the fair value accounting method is a significant contributor to the excessive leveraging, volatility and liquidity of the financial markets yet it can be established that fair value accounting technique is an important accounting valuation technique because no other accounting method provides as much transparency to the investor groups like this technique because this method provides the most appropriate valuation of the assets and securities held by the institutions and investor groups. Also, a main part of the financial crisis was said to be caused by bad lending policies followed by the banking and other financial institutions and at times by fraudulent activities carried out by certain entities in the market (Wahlen et al., 2000). Blaming this accounting technique as a primary cause of the crisis would be inappropriate. Rather, identifying that the fair value accounting method has been a messenger of the Global Financial Crises (GFC) would be more appropriate. Benefits and drawback of fair value accounting measurement The benefits and drawbacks of the fair value accounting practice can be assessed by comparing it with the other practiced methods of accounting like the traditional cost accounting method, the deprival value accounting method and the replacement cost accounting method. Benefits of fair value accounting It can be identified that the fair value accounting practice is the most suitable form of accounting that can be used by modern businesses because this practice enables the company to present a transparent and clear picture of the financial position including assets and liability values to the investor and other stakeholder groups. It helps to prevent any dubious accounting practices by the managers of a company and ensures better corporate governance on the part of the companies and higher transparency and information levels on the part of the existing and potential investor groups. This accounting practice acts as a value-reaping instrument in terms of providing better information quality to the stakeholder groups of the businesses. Therefore, the fair value accounting method acts in coordination with good corporate governance practices which ensures the development and maintenance of healthy accounting and reporting systems within a company. Additionally, the fair value accounting method eliminates the problems of profit smoothing functions and manipulations that are often done by the managers of a company to report inaccurate information in the financial reports published every year. This problem was commonly noted when the traditional methods of accounting were followed by the companies. However, the fair value accounting system helps to recognize the profits and losses incurred in the financial year which were normally spread over the life period of any financial instrument when accounted for under the other methods of accounting (Benjamin, Niskkalan and Marathamuthu, 2012). This process ensures that the earnings management processes of the companies are performed in more accurate and realistic manners (Leuz, Nanda and Wysocki, 2003). Drawbacks of fair value accounting method There are also few drawbacks of the fair value of accounting method as pointed out by the opponents of this technique. It has been argued that the use of the fair value accounting method for valuing the assets and liabilities of an organization operating in the secondary market often leads to lesser levels of reliability and accuracy of the financial statements. This is especially true in case the company in question is operating in a soft and volatile secondary market (Benston, 2008). Since the FVA takes into account the market prices of the assets, therefore, in case the market is volatile in which the prices change in a fast and unpredictable manner, the accuracy of the method declines (Ryan, 2008). However, the fair value accounting method is said to be the cause for additional inaccuracy, artificial representation and instability in the reporting of the financial positions of the companies and consequently in the financial markets as well (Laux and Leuz, 2009). This is because the fair value accounting technique often takes into consideration the immediate market value of the securities without appropriately considering the underlying fundamentals associated with the securities or the security holding entity. These kinds of problems associated with the accounting process often act in a collective manner thereby leading to the destabilization of the capital and financial markets in the long-term scenarios (Ramanna and Watts, 2008). Another drawback of this method is that the credit risk forecasting models and the valuation models of the illiquid financial instruments and the non-traded financial instruments have not yet been properly developed under this accounting technique. Two key issues are identified with relation to this which are that the determination of the preferred measurement scale for these instruments are the discounted cash flows or exit values and whether the companies should disclose the gaps between the discounted cash flows and the exit value of assets in the illiquid financial statements. Further, it can be pointed out that the FVA method is not adequately representative of the ways in which a business is managed internally and the short term decisions taken by companies regarding the management of securities and other assets. This is because this method is focused on the mark to market value and does not consider the fundamental management processes of the company (Ryan, 2007). A drawback of the fair value accounting method as compared with the traditional accounting systems is that the fair value accounting technique is widely criticised because of the pro cyclical nature of the technique which plays a major role in intensifying the troughs and peaks in an economic cycle. The FVA is criticised because it seems to reflect the asset values more effectively when the asset values are increasing while in case of the decreasing values, the FVA method becomes lesser efficient in terms of representing the value of the assets (Morris and Shin, 2008). Historical cost accounting The historical cost accounting method involves the valuation of the financial instruments as per the historic prices of the same. This causes a certain level of inaccuracy within the process of accounting as the current market factors are not taken into consideration. A benefit of the fair value accounting method as compared to the historical cost accounting is that in this technique the treatment of derivatives and others similar securities are done in an exclusive manner which ensures that the actual level of exposure of a company caused by these kinds of instruments is done as per the latest globally accepted accounting regimes. In comparison, the use of the historical cost based accounting methods lead to the valuation of the derivatives and other securities as per the primary acquisition costs of the instruments which are often very less though the level of exposure of the derivatives are higher in the financial markets as compared to other financial instruments (Watts, 2003). Thus, the FVA acts as a more effective method in the modern business world because of the transparency it adds to the accounting processes by taking into consideration the current values and factors affecting the values of the assets. Deprival value accounting The deprival values accounting method is seen as a solution for the accounting problems that arise in case of revenue recognition and earnings management, the deprival value method is renowned because it takes into consideration the liabilities and accounts for the relief values of the assets. As compared to the fair value accounting method, the deprival value method is far complex and may give rise to values that are not actually reflective of the market value of the financial instruments. Since, the fair value accounting method uses the mark to market values, therefore, the method supports the profit maximization approach taken up by organizations and is more suitable for the financial decision making purposes (Plantin, Sapra and Shin, 2008). The FVA is preferred for accounting in modern businesses because this method is simplified in nature, enables higher precision and accuracy of accounting and reporting and reflects the market values of the assets in a more practical manner. Replacement cost accounting Replacement cost accounting method focuses on the valuation of assets and liabilities at the prices that would have to be paid by companies to replace those assets or liabilities. A big issue in the way in which the changes in the value of assets can be accurately accounted for in this method is that while the accounting of gains or losses for the revaluation of assets as extraordinary gains or losses may be good for the assets whose prices are increasing, in the case of declining values of assets this method can significantly drag down the accounting incomes of the company. On the other hand, the fair value accounting method functions in similar patterns for both the increasing value and declining value assets and thereby makes the financial statements of the company more uniform in nature. The fair value accounting method acts as a more transparent and accurate method of accounting that does not have any negative impact on the accounting income reporting for a company because the current market values and the changes in the market values of the assets are considered appropriately for the calculation purposes. Conclusion It can be concluded from the above discussion that the fair value accounting method cannot be completely blamed for the global financial crisis. There are many other factors which have acted in a combined manner to cause the financial crisis. This form of accounting cannot be identified as the primary contributor of the Global Financial Crisis (GFC). Nevertheless, it can be said that the drawbacks associated with the fair value accounting like the pro cyclical nature of the method have added to the intensity of the crisis. But this accounting method cannot be termed as redundant because though there are some drawbacks of the fair value accounting practice, yet the benefits of this accounting technique clearly outweigh those of the other accounting methods. Thus, it can be said that in order to maintain an appropriate balance between the relevance and reliability of the accounting and reporting system followed by different companies, the fair value accounting technique combined with the use of historical cost and value figures for the assets would be most suitable. References Alexandera, D., Bonacib, C. G. & Mustatab, R.V., 2012. Fair Value Measurement in Financial Reporting. Procedia Economics and Finance, 3(1), pp. 84-86. Andre, P., Cazavan, J., Dick, W., Richard, C. & Walton, P., 2009. 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